Libor Transition – Dealers Seek FRTB Carve-out.

Banks are planning to ask regulators for capital relief during attempts to move roughly $370 trillion in swaps notional away from Libor to new interest rate benchmarks. Under incoming market risk capital rules – the Fundamental Review of the Trading Book – banks that model their own requirements will face a capital add-on for all risk factors not backed by a minimum level of trading. Studies have estimated these less-liquid portions of the portfolio could account for 30% of the total capital charge, but banks fear the Libor replacement project will drag far more trades in, as liquidity tails off in Libor swaps, and slowly builds in replacement benchmarks. “It seems to be two disconnected initiatives, for Lack of a better word. You have people who have their heads buried in Libor replacement work and people who are focused on the FRTB, but I don’t think many people are looking at the overlap of the two,” says a market risk head at one European bank.

Three market risk sources say the industry is now building a case for a carve-out request from the FRTB capital requirements while the market is transitioning to new benchmark rates. Discussions are said to be in their early stages.

“On the FRTB side, you need to have an intermediate carve-out and then settle on a final methodology once the Ibors discussions are on a firmer footing. Depending on how the Libor conversations work out, there may be another set of changes that have to be implemented in the FRTB to allow for this transition phase,” says the Head of Market Risk.

“Management is now starting to engage with local regulators to try and translate what quants are saying to regulators. I think probably in the coming weeks or months, we will hopefully get some sort of steer from the regulators.”

Some dealers expect the request to get a sympathetic hearing, given the high profile of the interest rate benchmark reform efforts. Over the past year, UK and US regulators have made increasingly forceful calls for the industry to retire Libor and switch to more stable alternatives. They have also recognized the stakes for the market. Speaking to last year, Federal Reserve chairman Jerome Powell emphasized the “big stability risk” if market participants were not able to transition smoothly to new benchmarks.

“This FRTB issue is an interesting aside, but it will not be allowed to stop the project. If necessary an exception will be made. It is perhaps a good example of one of the main flaws in the current FRTB rules – and this will surely be improved before the FRTB go-live,” says a risk manager at one global bank.

Observable obstacles

While FRTB still needs to be finalized – and is scheduled to go into force in 2022 – a number of jurisdictions are at the same time trying to wean the industry off Libor by creating new swap markets from scratch over the next few years.

In July last year, the UK Financial Conduct Authority announced a voluntary agreement for banks to support the Libor family of interest rates would conclude at the end of 2021, raising the possibility that the benchmarks will stop being published after that point. Regulators in various jurisdictions have either already selected a new risk-free rate (RFR) as a replacement benchmark, or are in the process of doing so. The new RFRs will be used both for new positions and as a rate to move legacy trades onto.

The US has picked a brand-new rate as its Libor replacement – the secured overnight funding rate (SOFR). The UK has selected a reformed version of Sonia, while Switzerland selected the Swiss average overnight rate.

Europe is yet to choose an RFR for euro-denominated trades, but results of a consultation asking the industry for its preferred rate, released on August 13, found 88% of respondents preferred the European Central Bank’s unsecured euro short-term rate over its two secured rivals.

Given the first SOFR-based swaps were only traded and cleared at LCH on July 17, market participants worry it will take some time for there to be sufficient trades referencing the benchmarks for banks to avoid capital penalties for illiquid trades.

Under the FRTB, a bank is permitted to include a risk factor – such as sensitivity to a specific interest rate – in its internal model for capital calculation if it can point to at least 24 so-called real price observations of the value of the risk factor over the previous 12 months, with no more than a one-month gap between any two observations. Failing this, the risk factor would be deemed non-modellable and attract an additional capital charge.

“If the new rates aren’t formed from observable underlying transactions, then theoretically they would be classed as non-modellable risk factors, and subject to an additional stress-based add-on,” says one risk manager at a US bank.

The definition of price observations includes transacted prices and some committed quotes. It’s unclear how much leeway banks will be given, to use proxies – for instance, whether they can set their own tenor buckets to catch multiple trades, or whether these will be regulator set. Data-pooling schemes may also be able to help banks get over the 24-transaction barrier.

Industry studies have shown the NMRF framework can contribute as much as 30% of total capital under the internal model’s approach.

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